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Trade Notes: CQS’ Distressed Debt Fund

Distressed debt: picking up pennies on the dollar, sometimes in front of a bulldozer.

The idea of distressed debt investing is simple enough: most of the time, debt is bought by institutional investors (otherwise known as long-only investors, or long money) in the hope that the steady (generally in the 6-10% annual) interest returns will be good enough for their long-term obligations. Then, as the debt cycle gets more and more speculative, you have everyone and their grandmother (sometimes literally) piling in. As the correction inevitably comes, borrowers can’t pay and lenders panic, and debt starts selling at a discount (i.e., if you are the unlucky owner of a dollar of debt, you want to get rid of it quickly, and are willing to sell at a discount, sometimes at pennies on the dollar). That’s distressed debt.

Distressed debt investors can (and often do) make a killing in buying up this distressed debt at deep discounts, often in very unlikely places. Enron (yes Enron) debt, for example was still paying off for one hedge fund in early 2008.

During the LTCM (Long Term Credit Management, if you’ve never heard of them, you shouldn’t be reading this) crisis, Warren Buffett was really interested in buying out LTCM’s whole portfolio (that went into the billions of dollars) at a discount. He didn’t much like the Fund, or the managers (they violated his “no-assholes” rule) but he knew he’d make out like a bandit because he (unlike LTCM or its bankers) could hold out for the long run. He still regrets not being able to buy that one. More recently, if you’d bought Ford debt (already junk and selling at steeper discounts) at the beginning of the debt crisis, you would have made a tidy packet.

The cycle is now turning and distressed debt should be coming back. That’s not too surprising, a lot of debt holders have been holding on for dear life to their portfolios, in the (I think) vain hope that they won’t have to mark their books to a dismally distressed market before the debt comes due. Most of the stuff they’re holding is justifiably crap, and the foolish debt investor will get his just dessert for not doing his homework right, if at all. A very small subset of that stuff will be good debt, backed by good fundamentals, held by investors who are distressed. Think some of the better Dubai Inc. holdings (Emirates Airlines comes to mind) debt. That stuff had to be unloaded by Dubai because of trouble elsewhere, and was mostly snapped up by fellow UAE member (and 900 kg gorilla) Abu Dhabi at some discount. A few more things will be more difficult to get money out of, may actually not pay up well, but would be interesting to look at with very steep discounts. Needless to say, that’s when you need to have a good nose for what will work, and a lot of spare cash. If you’re not Warren Buffett, I suppose it wouldn’t hurt to be invested with Michael HIntze.

I’ve always had rather mixed feelings about distressed debt funds; goes with the mixed experience I’ve had with them. Most of them turned out OK but what they all had in common was a singular unwillingness to communicate much of anything to the client. Now it looks like CQS, run by Michael Hintze, is closing that circle. I’ve been invested in his main convertible fund, which did pretty well. I also dearly wanted to be invested in his Directional Opportunities Fund (CQS DOF) but the hard liquidity terms caused some investors to balk. As this FT story says:

Between April and December last year, the distressed portfolio of the CQS Directional Opportunities fund returned 55 per cent, and was up 13 per cent this year in the run-up to June, when the new CQS fund was seeded.

The DOF is actually a lot more than that: essentially a portfolio composed of all the weird stuff Michael Hintze thought would be highly profitable but couldn’t put into the bigger portfolios because of liquidity or volatility constraints. It was also (at least the last time I talked to them) the only portfolio solely managed by Michael Hintze. Michael never divulged anything of much import to his investors. That bothered me a lot, but I held my nose and invested in the main Convertible Fund because of his oft-repeated promise to “provide steady returns with low volatility.” That promise went by the board in 2008, though he did deliver a pretty good performance afterward.

Never one to give up an opportunity to garner fees, CQS is now jumping in and launching a distressed fund. I bet this one will:

Be pitched at the Institutional Investors and FoHF’s looking at distressed allocations;

Have better liquidity than the DOF;

Will be BIG;

Will promise “steady returns with low volatility”.

All things considered, I’d rather invest in the DOF:

It will be volatile, but I expect this sort of investment to be volatile;

It will probably remain small (now USD 830 million) because the liquidity will chase off all but the most long-term investors:

It will be backed by CQS’ very large credit team (paid for by investors in the main Funds) but will have Hintze in charge.

Granted, I still wouldn’t get to see or hear Hintze much, but at least it’d be honest and have someone I consider to be one of the canniest credit/convertible investors actually in charge. So, pass on the distressed fund, but still long on DOF.